Alan Rowsell
Premier Miton Global Smaller Companies Fund manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Global small caps can provide several benefits to an investor
They offer the potential for higher returns over the long term. They can help to diversify risk in a portfolio and there is also the potential for an active approach to generate outperformance or alpha compared to an index as smaller companies (small caps) are a less researched, less efficient part of the market. One additional benefit to the active investor is they can provide a valuable market timing signal, which can help us understand where we may be in an increasingly complex economic cycle.
A little bit of history repeating?
Looking back over past equity market cycles, small cap performance has been correlated to economic activity with small caps tending to outperform when an economy picks up and underperforms when it slows. Arguably, the best time to buy small caps has been during recessions at market low points. Small caps tend to perform strongly during economic recoveries and usually covering periods of 3-4 years. Sometimes small caps may even start outperforming large caps early in a recession and before a final low in the wider market is reached.
This can be seen in the chart below which shows the average performance of US small caps over the last 6 recessions since 1980. You can see that the best time to consider an investment in small caps is in the grey box which indicates the recessionary period. You can also see that small caps tend to underperform in the 2 years prior to a recession as the economy slows and tend to have a last downward leg just as the recession starts.
Small cap relative performance turns around recessions
Source: Bloomberg, William Blair Equity Research 1980 – 2022. Past performance is not a reliable indicator of future returns.
Tomorrow’s news today?
Comparing this to today, it is interesting that global small caps have now underperformed for 2 years, as you can see in the chart below. They have also taken a sharp downward step in recent weeks caused by investor risk aversion stemming from the collapse of Silicon Valley Bank. Based on the historical pattern, this price action suggests we may now be in the grey box and a recession could be underway.
Our analysis of economic leading indicators supports this view and if a recession has not just started in the US, it is likely in the next few months. Therefore, global small caps could be at or close to a cycle low and possibly on the cusp of a positive, upwardly mobile trend.
Small cap performance relative to large caps over last 3 years
Small cap companies are represented by the MSCI AC World Small Cap Index and large caps by the MSCI AC World Index – the data here is for relative performance. Relative performance measures how one index is performing relative to another index and is a good sign of strength or weakness.
Source: Bloomberg data from 30.06.2020 to 03.05.2023. Past performance is not a reliable indicator of future returns.
When lived in real time rather than in hindsight, market lows are a process rather than a single point in time and the best approach may be to add to investment positions incrementally. An old market saying is that “no-one rings a bell at the top of the market” and it is the same at the bottom. Timing precisely the market low is all but impossible, but we can identify where we think we are in the cycle and the period of time to when small caps may bottom and inflect.
An end to the land of giants?
A possible positive for small caps would be the bursting of the large cap technology bubble. For well over a decade, large cap tech has produced strong returns, outperforming all other sectors year after year. However, the valuation of company shares that expanded during the era of zero interest rates are under pressure, while many of the tech giants like Apple, Microsoft and Google are so big that the law of ‘large numbers’ kicks in, limiting future performance. The law of large numbers shows that a large entity which is growing rapidly cannot keep that growth pace forever. The biggest of the blue chips, with market values in the hundreds of billions, are often cited as examples of this phenomenon.
As you can see in the chart below, large cap tech company share prices represented by the NASDAQ 100 Index has performed positively in recent weeks. However, the chart also shows how large cap tech appears to have stalled out over the last 3 years and the latest rally may be short lived.
Bursting of a large cap tech bubble?
Technology companies here are represented by the NASDAQ 100 Index, a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange.
Source: Bloomberg data from 08.03.1996 to 03.05.2023. Past performance is not a reliable indicator of future returns.
Valuation matters and the price you pay for a company’s future earnings stream is a key factor in deciding an investor’s return. It is reassuring to see that valuations of small caps are now close to 10-year lows. In absolute terms, the forward Price to Earnings ratio (PE) of global small caps is 15.5x, a slight discount to global large caps at 16.2x as at 03.05.2023. Forward price to earnings ratio shows what the market is willing to pay today for a company share based on its future earnings.
Small caps usually trade at a premium to large caps because there are a lot more loss-making small cap companies that inflate the average multiple. However, this premium has disappeared suggesting small caps are relatively cheap in our view.
Global small cap valuations at 10-year lows
Source: Bloomberg data from 10.05.2013 to 03.05.2023. Global small caps: MSCI All World Small Cap Index. Global large caps: MSCI All World Index. Past performance is not a reliable indicator of future returns.
The more you know about the past, the better prepared you are for the future
History shows that the best time to buy small caps may be at the bottom of the economic cycle. We believe a recession is now unfolding in the US and the next few months will present opportunities in global small cap stocks. Large cap technology stocks appear to have peaked in market valuation, while small cap valuations look attractive to us. Now may be the time for investors to consider the merits of global small caps investing again, an asset class quite possibly on the up.
